By Dr. James M. Dahle, WCI Founder
A famous football coach once said, “You're never as good as you think you are when you win, and you're never as bad as you feel when you lose.” Investors should modify that quote just a little bit to help them maintain perspective and stay the course with their investing plan.
You're Not as Rich (or Poor) as You Think You Are, and That's OK
It is the natural tendency of an investor to assume that their account balances are what they really own. Aside from the fact that the government owns some as-yet-unclear portion of your tax-deferred accounts, this is a very misleading attitude that leads to poor financial decisions. The “wealth effect” is well-known.
What Is the Wealth Effect?
The Wealth Effect refers to the fact that people spend more when their assets increase in value, such as a run-up in stocks and real estate prices. The Wealth Effect changes an individual’s perception of wealth—they feel richer, even though their income and fixed costs have not changed. At its worst, people use their home equity as ATMs, pulling it out to spend it on consumer items. While you would think the wealth effect is a behavioral error that you should work hard to avoid, it isn't all bad. At market highs, future expected returns are lower, so maybe that should tilt the spending vs. saving balance a little bit.
Bull Markets and the Wealth Effect
Assuming a long-term investment horizon, the reality is that at near bull market tops, you have lower expected future returns and lower yields from your portfolio. Yes, you have more money in the account, but the money is actually worth less than it used to be! Don't spend too much time congratulating yourself on your investment acumen and counting your wealth. A good percentage of it, perhaps even half of the money you have invested in risky assets, is almost surely going to disappear temporarily at some point in the next five years.
An even worse tendency on the bull market side is the idea that your account balances have gone up dramatically in the last few years because you're a brilliant investor. As John F. Kennedy said (admittedly in a different context), a rising tide lifts all boats. From 2009 until the beginning of 2022, you could have bought just about any asset and done great. By April 2021, over the previous decade, US stocks were up 264%, international stocks were up 66%, large growth stocks were up 352%, small value stocks were up 250%, and REITs were up 135%. Bonds were doing fine too with TIPS up 38% and nominal bonds up 53%.
Even precious metals had positive returns over that decade. Housing prices went up dramatically as well over the last decade.
Meanwhile, inflation, though it rose dramatically in the first half of 2022, had been very low at 1.7% per year for the previous 10 years, so the vast majority of those exceptional returns were real, after-inflation returns, at least in the way CPI is calculated.
Should You Cut Your Losses and Sell Out at Market Lows?
Lots of investors, including many physicians I know, sold out at the market lows of 2008-2009. They looked at their recent losses and compared their balances to how much they used to have and how much they needed in retirement and decided they could not afford to lose anymore. Perhaps if they remembered that they really didn't have as much as they thought they had in early 2008 or as little as they thought they had in March 2009, they would not have done so.
Should You Try to Time the Market?
Playing around on the edges
I'm not advocating that you somehow try to time the market. Remember, a bear market is a semi-regular occurrence. You will lose some money in bonds. You will lose some money in stocks. You will lose some money in real estate. You will lose some money in precious metals. The only reason to change your asset allocation (investment plan) is in response to changes in your need, ability, and desire to take risk.
I think it is OK to play around on the edges, perhaps a 5% variation in your stock-to-bond ratio, perhaps putting a little more money into paying down debt and a little less into your investment portfolio, perhaps rebalancing a little more often, etc.. But realize that these little moves are probably just as likely to cause you to lose money as to gain it.
Don't believe me? Write down the little changes you make and the reasons you made them and go back in a year or two and see how clear your crystal ball was. It might satisfy an urge to tinker. Better to make little mistakes than big ones.
The reason that market timing is so difficult is that not only do you have to figure out what will happen in the future, but you also have to time two events at least relatively successfully—an exit and an entrance. This is surprisingly hard, even for an unemotional Spock, but add in some of the emotional effects caused by greed and fear, and it is nearly impossible. As John Bogle said about market timing,
“After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know of anybody who knows anybody who has done it successfully and consistently.”
How to Combat the Wealth Effect
So, what should the investor do to combat the wealth effect? The same thing they always need to do. Stay the course. If you're still a decade or more away from retirement, just stick to your written investing plan. Keep your 60% (or whatever) stocks in bull markets and in bear markets. Don't get greedy and abandon bonds, especially out of an irrational fear of some bond bear market. Do not start spending more or buy a bigger house because your balances seem large. Remember that a significant chunk of your investment account isn't really there.
What? You don't have a written investing plan in place? Well, go get that first. Consider taking my online course (cheaper but more work required) or hiring a good financial planner (more expensive but less work required) so you know exactly what to do with your money.
If you are very near retirement (at the point where a bear market in the next five years would cause you to have to work longer), take a look at your need to take risk. Perhaps you no longer need 8% returns to meet your goals. If you no longer have a big need to take risk, perhaps this is one of those times to dial back the risk in your portfolio a bit.
At market highs, consider paying off your mortgage and student loans with new savings. Those returns are guaranteed no matter what the stock and bond markets do. Maybe also step up your giving and donate appreciated shares to charity; even if the market goes down later you will still get the full tax deduction, and in the meantime, your money can do some good in the world.
Excellent points. A common emotional tendency that even I find myself making. How dangerous do you think it is if you feel wealthier but don’t live/spend wealthier because we are in a bull market?
It is hard not to have some emotional link to your investment value. When the market is high I feel great, when there is a drastic drop, not so much.
You hinted at it a bit in the post, but what has recently got me worried is what is the true inflation that is going on and not what is just fed to us as a derivative of CPI. The basket of items included in the CPI does not reflect a lot of daily things we use. I came across the Chapwood index which tries to include real loss of purchasing power and was shocked that in many cities it approached 10% inflation annually (go to your local lumbar store and tell me there is only a 2% increase or not). This makes me feel a lot poorer than I thought before.
That’s a great unintentional typo given your profession….lumbar.
Lumber, housing, education, health care all up. Food, clothing, tech, autos down. The only rate that matters is your personal rate of course, but that’s different for everyone. Housing doesn’t affect you if you’re already in your forever home.
FIREd up, in a low cost state, COLA pensions (until he dies then 40% drop pension, and he just had an MI way too young- if I die just 14% drop), but hope it all needs to last another 40 years. So, money management (me) doing nothing different but bragging more or less to him depending on if I check the account balances at a high or low. And quite clear to myself if not to him that I had no effect beyond getting funds into investment accounts and keeping most of them there.
Await Covid resolution and also settling down post my retirement this year to see what drawdown strategy seems best and what our actual needs are likely to be longer term. I figure we dollar cost averaged going in, and the opposite would be %age withdrawals; pulling in our spending any year 2, 3, or 4% is less than it was the previous year if we were going to push those limits. Will be trying to expand spending to get to those drawdown rates as things shake out, and limiting new long-term money sinks like a costlier/ additional car/boat, a new dependent (at our age one of our parents or a charitable hobby not another kid), or a convenient place near the kids (without offloading the current house). Goals: minimize kids’ inheritances and avoid them having to support us.
I am seven years from ‘retirement’. Since the market rebound, I have been moving my portfolio a little bit more conservative than my written investment plan, from 65-35 to just over 55-45. I have a small value tilt with lots of international exposure and I have left those alone. But, with the S&P and growth up so much over the last six months I have trimmed those holdings.
I know this will likely mean my portfolio won’t grow as much as the market. But, one of my goals is to have 10 years of living expenses in cash/bonds (by retirement) and accelerating that plan right now makes sense to me (even though part of me feels this will hurt compounding and may be stupid). Also, my overall plan is pretty conservative, with future expectations of total portfolio real return at 2% (for model purposes).
To be clear, I am not trying to time the market. My focus is on using the strong bull to fund my conservative tranche. Ideally, these funds are not going back into equities. It is hard, though, to see my portfolio lag the market on Personal Capital.
p.s. just read the post on reducing risk and quitting when you’ve won the game. Now I need to considering moving even more aggressively conservative.
My retirement goal is based on portfolio balance instead of a specific age, so our recent bull market pushed me over the next financial milestone where my written plan calls for a shift to a higher percentage in bonds.
I did the math using some real dollar amounts & a variety of projected future returns and was pleasantly surprised to find that once you’re fairly close to your financial target, there really isn’t much of a difference between 80/20 and 70/30 in how long it will take to get to your goal.
man you guys are doing awesome with your written financial plans! I myself have fallen victim to the wealth effect, but I do not compromise saving 20% of gross income for retirement, and definitely having a written financial plan helps in this regard. Luckily there was extra money given covid that I saved, but now as covid is abating the real work begins to not inflate lifestyle and spending as my wealth has grown. Having all retirement savings automatically deducted from my paycheck also helps keep me and the wife honest.
For the vast majority of people, their needs have not increased. They may have more money, but no need to spend any more of it. We have more money than we did 10 years ago, due to savings and market returns. But our spending has gone down. We already have the things we need. No need to get a new car just because the market has gone up.
Does no one suffer from the opposite effect of feeling less wealthy as their NW increases? I am early in my career, just 4 years out of fellowship. Luckily I have been blessed with a good paying specialty with a nice shovel and we enjoy living a LCOL area where our family is, while still being close to 3 massive metropolitan cities. In those 4 years we somehow managed to go from a networth of negative 200k to a networth exceeding 7 figures despite some mistakes along the way.
As I watched our networth increase, I am getting more and more focused on accelerating that increase even more. Spending on things that did not concern me before like trying to save on groceries, avoiding overpriced coffee from Starbucks and changing my 10 year old car have become even more important.
If any thing I feel “poorer” than I did coming out of training, because I am trying to save more, invest more, and have a smaller disposable income. By no means are we living an uncomfortable life though. Just an interesting opposite effect for us.
Yes, you’re in a minority, but if you’re not careful, you’ll become miserly. You certainly don’t need to stop buying Starbucks coffee if you could build a 7 figure net worth in 4 years while drinking it.
https://www.whitecoatinvestor.com/loosening-the-purse-strings/
You are making a financial mistake in the opposite direction. It’s not uncommon among the self-selected people who follow this blog. Save 20 to 30% of gross income for retirement, but don’t hesitate to spend the rest in a manner that brings your life meaning and enjoyment. If you’re depriving yourself on a 7 figure net worth, you’re doing it wrong. Trying to skimp on coffee with that kind of net worth 4 years out of fellowship is, pardon the bluntness, ridiculous. Balance, my friend. Moderation in all things.